Stepping on the gas too much?

​​Quarterly Economic Outlook

Too much gas? Economy heating up in 2018

The economy posted solid growth of 2.3 percent in 2017 (2.5 percent on a quarter-over-quarter basis), in line with our expectations. Growth of 2.3 percent roughly equaled the average annual growth rate during the current expansion (of 2.2 percent). Consumption fueled the bulk of economic activity at roughly 70 percent of GDP. As we've said before, without policy changes, it is virtually impossible to generate noticeably faster-than-average economic growth. Those policy changes have now arrived and they should boost economic growth this year. Fiscal policy measures enacted by Congress should provide a stimulus to growth, pushing it toward 3 percent in 2018. While this is only 80 basis points greater than the annual average, it would nonetheless mark the strongest calendar-year growth rate during the current expansion. Partially because of these new stimulative measures, we estimate the probability of a recession over the next 12 months at roughly 20 percent.

A somewhat resurgent economy should provide support for commercial real estate (CRE) demand, even at this relatively late stage of the property market cycle. Although net absorption for a number of property sectors has declined from cyclical peak levels, the stimulus could provide a temporary increase in 2018. Construction might also bump a bit. The expensing provision in the tax legislation now allows investors to deduct 100 percent of investment costs from taxes in the year that monies are spent. Investors no longer have to depreciate those investments over many years. But construction still remains largely a function of underlying CRE market fundamentals, which are unlikely to change enough to dramatically impact construction levels.

The most impactful change could come from the investment market.Favorable tax legislation could provide the impetus for increased transaction activity,luring some dry powder into the game from the sidelines.

While we do not anticipate a return to peak transaction volumes or prices, real estate benefitted significantly from the tax legislation and many investors seeking a vehicle for their capital could find ample opportunities in CRE. Despite the long run of good performance and the favorable policy changes, we're still not seeing the excessive exuberance that has characterized the latter stages of previously market cycles, at least not in CRE. But if too optimistic feelings continue to resonate throughout the economy, the CRE market will need to guard itself against getting swept up in the fervor.

Our key concern for our outlook remains higher interest rates. Although rates have been rising for more than two years, they have done so slowly. That could change in 2018. Wages growth and inflation were accelerating before the impact from fiscal stimulus. If both of those continue to accelerate, even without spiking, the Fed could feel compelled to raise rates more quickly, hoping to get ahead of an overheating economy. Over time higher rates begin to drag on economic growth and, ironically, could hasten the end of the current expansion. Therefore, the probability of a slowdown increases in the latter half of 2019.

What's driving our outlook? Fiscal policy steps on the gas

The federal government has embarked on an unusual path for fiscal policy. Congress passed a roughly $1.5 trillion tax cut over a 10-year period in late 2017. This measure was set to boost growth by roughly 50 basis points versus 2017's growth. Then just last week Congress approved increased spending caps of roughly $500 billion over the next two years. Never before has such a late-stage stimulus been attempted. Typically such measures occur during recessions or at the early stages of expansions when the economy has been relatively weak. We would have been far more supportive of these measures if they had occurred during or just after the Great Recession. Stimulating the economy at a time when output is already running close to its long-run potential growth rate and unemployment is hovering near the natural rate can push aggregate demand and increase GDP growth. But, the fiscal policy measures implemented do little to address aggregate supply or production, which remains the major force holding back long-run growth. Production remains limited due to declining labor force growth and weak productivity growth. Labor force growth is slowing due to the aging population.

Baby Boomers who once spurred labor force growth are now dragging it downbecause roughly 10,000 of them retire every day. ​

Subsequent generations will increase the absolute size of the labor force, but cannot produce the growth rates the Baby Boomers did when they entered the labor force. Meanwhile, productivity growth continues to decline over time—a trend all economies experience as they become more developed. Technologies like electricity, plumbing, and mechanization provide significant productivity gains at early stages of industrialization, but become more difficult to repeat as economies become larger and more sophisticated. And that results in long-term declines in productivity growth. Even the Internet, the most recent example of such technology, boosted productivity for only about 10 years. After the Internet became an established part of production, productivity growth reverted back to its declining trend. ​

Without improvements in labor force growth or productivity growth, the economy can race ahead of its long-run potential growth rate on a short-term basis, but not on a prolonged basis. The tax legislation could provide some support to productivity growth by spurring investment, but not enough to keep pace with aggregate demand growth. The spending package simply spends dollars and does not directly address any of the production issues. Neither legislation directly addresses the labor force by either directly addressing the demographic challenges or by funding improved worker education and training. The legislative changes could provide a short-term boost to hiring by pulling some workers back into the labor force. But six million jobs remain open but unfilled, demonstrating that a lack of qualified workers, not jobs, remains the key issue in the labor market. Job growth peaked in 2014 and has declined every year since. Unsurprisingly, wage growth has picked up its pace as labor has become increasingly scarce. In January, year-over-year wage gains reached 2.9 percent, its highest rate since the recession. Although declining hours worked partially contributed to this, the trend over time for wages remains upward, if uneven. Over time, wage gains tend to produce stronger inflation, even if the interval from wage gains to inflation varies.

Therefore providing this demand-side stimulus now not only fails to seriously address the long-tern supply-side production issues but also risks overheating an economy that is already quite healthy without a true need for such a remedy.

Interest rates could hit the brakes

The risk of overheating is sharpening minds at the Fed. The Fed has taken pains to avoid addressing the issue of fiscal stimulus directly, but this issue clearly factors into its analysis. In recent meetings the Fed's tone and statements have become a bit more hawkish, reflecting the members' growing concern. The Fed's forecast calls for three rate hikes of 25 basis points each this year, with the first one likely coming in March. But the risk to a greater number of rate hikes now lies on the upside.

We are holding our forecast at three rate hikes for this year, but we wouldn't be surprised if the Fed felt compelled to tighten four times this year.​

Meanwhile, the long end of the curve has already responded to accelerating inflation and wages. As we warned, rates moved quickly. The 10-year Treasury yield recently hit a four-year high (approaching 2.9 percent) while the 30-year Treasury yield passed above 3 percent, hitting its highest level since last year. We forecast that the 10-year yield will end the year in the neighborhood of 3 percent, if not a bit higher. But much like at the short end of the curve, the risk here is fixed on the upside.

Higher rates across the yield curve should not mean too much for the economy and the CRE markets this year. Although the rate of change has been somewhat abrupt, the levels are still low enough to be simulative. But the punch bowl is slowly being taken away and over time higher rates could put the brakes on the expansion and offset some of the simulative impact of the legislative changes. We remain concerned that in the medium run, higher rates will start to drag down the expansion and could even shorten its duration when compared to a scenario in which simulative legislative changes had not been passed. And that would provide a pyrrhic victory, at best.

Risks and closing thoughts

The economy and market should have much to cheer in 2018 and even into the first half of 2019. But our caution centers on what could happen after stimulative fiscal policy eases off the accelerator and higher yields start to tap the brakes. Objectively, the federal government has undertaken an interesting economic experiment of late-stage fiscal stimulus. It could certainly end well, but empirical evidence and economic theory suggest otherwise. Better to be safe and fasten your seat belt.